Risk Management Part 4: Who’s using the futures market and what are their intentions?

In my previous article, I discussed four possible market environments and the possible marketing or hedging strategies for each environment. Cow-calf producers will know if the basis is weak or strong based on longer-term historical data. The price range of the futures market over the past two years will provide a good idea if the futures market is in the upper or lower half of the reasonable price range. This type of data is considered concrete because it is mathematically or statistically calculated.

ADVERTISEMENT

Producers often ask what other information besides the statistical or mathematical data should come into play when making marketing or hedging decisions. There are a couple of features of the futures market I will discuss that can turn the basis from weak to strong in relatively short period.

The feeder cattle futures market (which trades on the CME Globex electronic platform) is the price discovery mechanism for North American feeder cattle. The contract is 50,000 pounds and is based on the CME feeder cattle index. Without going into detail, this feeder cattle price index is based upon a sample of transactions in the 12 major feeder cattle producing states for 700- to 899-pound medium- and larger-frame feeder steers with data provided by the USDA. The CME publishes a composite price daily, which is the official cash settlement price for the CME feeder cattle futures at contract final settlement. Obviously, producers don’t have time to collect and watch all this data so it is important that they look at these published prices. Below is an example from February 21 through to March 3. In my weekly commentary for feedlot operators, I always show these values.

ADVERTISEMENT

ADVERTISEMENT

Notice the cash price dropped about $2 from Feb. 21 through March 3; however during this same timeframe, the March feeder cattle futures market dropped nearly $7. What could be a relatively weak basis on Feb. 21 would be considered a rather strong basis on March 3. The feeder cattle futures market appears to be leading the cash market lower. Of course there will always be some feature packages that trade higher during the week but this provides the overall trend of the market.

One producer asked me what the most important piece of information is when trading futures market for a short- to medium-term time horizon. Producers should know who is long and who is short and how much of each. The Commitment of Traders report is released on Friday afternoon showing the data from the previous Tuesday. There are three categories on the report. The commercial traders are the ones that use futures market to offset risk in the cash market. The non-commercial is the larger speculative trader (such as hedge funds) and the small speculator is the all-other-traders. There is also the Commitment of Traders Disaggregated Report, which removes the Swap Dealer into a separate category. Below, is an example of the weekly data from the Commitment of Traders Disaggregated Report (futures contracts only).

The commercial trader is the producer, merchant, processor or user. If the commercial trader has a huge short position, this means that that the market has to go down. Remember, the commercial trader uses the futures market to offset risk so if the commercial trader has a record short position, this means they also have a large long position in the cash market. The market needs to go down to encourage demand.

On the flip side, we have the next Managed Money category, which refers to the large speculator. This can provide an idea of the overall trend of the market because they are trend followers. The managed money will often push the market to extremes. There can be periods when the commercial trader is not buying any cattle in the cash market so the large speculator pushes the market higher to levels where the farmer selling becomes more significant. Producers should have a long-term perspective of the managed money position.

The accompanying chart below covers June 5, 2017 to February 27, 2018. On October 31 2017 the managed money had a record long position and this is also when the feeder cattle futures traded at 161.50, which was a fresh 52-week high. This is also when the commercial had a record short position. The market has never made it back up to this high. This is a very strong indicator that producers need to watch weekly to help place hedges or buy their price insurance.

About the author

Jerry Klassen manages the Canadian office of Swiss-based grain trader GAP SA Grains and Produits Ltd., and is president and founder of Resilient Capital specializing in proprietary commodity futures trading and market analysis. Jerry consults with feedlots on risk management and writes a weekly cattle market commentary. He can be reached at 204 504 8339.